Jan. 25 (Bloomberg) -- The U.S. Securities and Exchange Commission is updating rules for how mutual funds value holdings after they struggled to price mortgage-backed investments during the subprime-lending crisis.

Regulators are reacting to an explosion in derivatives and mortgage-backed bonds that don't always trade on exchanges, said Douglas Scheidt, an associate director in the SEC's investment management division. The guidelines, to be proposed this quarter, will set out steps to value assets when trading prices aren't available, he said.

``Funds seem to be relying on stale pricing on several occasions,'' Scheidt said in an interview today. ``They were continuing to value the securities at prior levels'' even though ``facts would suggest that the price would have gone down.''

Bank of America Corp., SunTrust Banks Inc. and Legg Mason Inc. all propped up funds holding mortgage-linked securities in 2007 after markets dried up amid the worst U.S. housing slump in 17 years. Federal Reserve Chairman Ben Bernanke last week said the lack of prices for such securities helped erode investor confidence, contributing to billions of dollars of losses.

The new rules, which will be binding for companies registered under the Investment Company Act, mark the agency's ``first comprehensive'' revision in four decades, Scheidt said.

Realistic Prices

The effort, which may also prove useful to hedge-fund managers, will lay out the degree to which mutual funds can rely on price quotes from brokers and professional services, Scheidt said. The guidelines will also address the responsibilities of funds' boards of directors to make sure assets are correctly valued, he said.

``The subprime crisis has helped motivate the SEC to take another look at valuation,'' said Elizabeth Knoblock, a former SEC attorney who's now a partner at Mayer Brown in Washington. Over the past few years, ``the SEC staff was fairly laissez faire'' unless they caught an investment adviser ``inflating assets to charge more fees.''

Mutual funds determine the net value of their portfolios each day. That sets prices at which existing investors can sell shares back to the fund and new investors can buy in. Fund managers base calculations on trading prices ``readily available'' from exchanges, according to SEC rules.

Infrequent Trading

When prices don't exist because an exchange is closed or an asset is infrequently traded, funds base valuations on prices for which they can reasonably expect to sell. In such cases, fund managers rely on quotes from brokers and pricing services.

Inaccurate asset prices may prompt mutual-fund managers to overestimate a fund's net value and overpay when shareholders sell back their stakes. That can shortchange long-term investors.

When demand for subprime-backed debt dried up last year, more than 80 percent of investment managers had difficulty obtaining prices for mortgage-related investments, according to a September survey by Greenwich Associates.

Brokers stopped providing quotes out of concern they might have to honor the prices and buy back securities that had plummeted in value, said Timothy Sangston, a managing director at Greenwich Associates, a financial-services consultant based in Greenwich, Connecticut.

SEC Commissioner Paul Atkins said in a November speech that the market tumult showed the need for updated ``valuation'' guidance vetted by the agency's commissioners. The new rules will require approval by agency commissioners and SEC Chairman Christopher Cox, Scheidt said.

Other Efforts

The SEC is pursuing other ways to improve valuations of thinly traded securities.

The agency, along with other regulators, held discussions with NYSE Euronext, which owns seven exchanges in the U.S. and Europe, about providing a ``facility'' that would disclose derivative price quotes and trading data, NYSE Chief Executive Officer Duncan Niederauer said during a press briefing at the World Economic Forum in Davos, Switzerland today.

Within the $12.1 trillion U.S. mutual-fund industry, the biggest subprime-debt investors are taxable bond and money-market funds, which managed a combined $3.93 trillion of assets as of November, according to the Investment Company Institute.

Money funds, which try to maintain a stable net asset value of $1 per share, are considered among the safest investments because they only buy highly rated debt with short maturities. Falling below a $1 a share can shake investor confidence and spur withdrawals.

Cash Injections

To prevent investor losses, Baltimore-based Legg Mason has arranged $1.47 billion in financing for its money-market and cash funds since November. In December, Atlanta-based SunTrust injected $1.4 billion into two money funds, and Bank of America, the second-largest U.S. bank, said it would wind down a $12 billion cash fund. Cash funds, which are sold to institutions and wealthy individuals, offer higher yields by investing in riskier assets.

Bernanke said in Jan. 17 testimony before the House Budget Committee that the lack of pricing data has put stress on financial markets.

``As investors lost confidence in their ability to value complex financial products, they became increasingly unwilling to hold such investments,'' he told lawmakers.

At Wall Street banks, the collapse of the subprime-mortgage market has prompted more than $130 billion of writedowns. Merrill Lynch & Co., the biggest U.S. brokerage, has reduced the value of its assets by $24.5 billion and Citigroup Inc., the nation's largest bank, has absorbed $19.6 billion in losses.

To contact the reporters on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net; Miles Weiss in Washington at mweiss@bloomberg.net.

Last Updated: January 25, 2008 13:57 EST